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CHAPTER 1
BUSINESS: WHAT’S IT ALL ABOUT?
CHAPTER OVERVIEW
The chapter begins with a discussion of the purpose of a business, including a discussion of both
for-profit organizations and not-for-profit organizations. Next, the nature of business operations
is discussed. The four types of businesses are discussed: service, merchandising, manufacturing,
and financial services. The first part of the chapter concludes with a discussion of the general
forms of business ownership: sole proprietorships, partnerships, and corporations, including the
advantages and disadvantages of each.
The second part of the chapter begins with a discussion of business activities and the events,
resources, and agents affecting business transactions.
The third part of the chapter discusses the nature of information in general and accounting
information in particular. The users of accounting information are discussed, including
management, regulators, creditors, and investors.
The last part of the chapter is an introductory discussion of the four basic financial statements
(each financial statement is discussed in detail in later chapters). The balance sheet is introduced,
along with the accounting elements: assets, liabilities, and shareholders’ equity. Next, the income
statement is introduced, along with the accounting elements: revenues and expenses. The
statement of changes in shareholders’ equity is then explained, including the common causes for
changes in the equity accounts. Lastly, the statement of cash flows is introduced and compared
with the information presented on the income statement.
At the end of the chapter, there is a short discussion of general business risks, including general
strategic risks, operating risks, financial risks, and information risks.
LEARNING OBJECTIVES
After completing Chapter 1, your students should be able to:
1. Describe what a business does and the various ways a business can be organized.
2. Classify business transactions as operating, investing, or financing activities.
3. Describe who uses accounting information and why accounting information is important
to them.
4. Identify the elements and explain the purpose of the four basic financial statements
—the income statement, the statement of changes in shareholders’ equity, the balance
sheet, and the statement of cash flows—and be able to use basic transaction analysis to
prepare each statement.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1-1
5. Identify the elements of a real company’s financial statements.
6. Describe the risks associated with being in business and the part that ethics plays
in business.
CHAPTER OUTLINE
Purpose and Organization of a Business (LO 1)
I. A business is formed to provide goods or services for the purpose of making a profit for
its owner or owners.
II. To start a business you need capital.
a. Capital is the name for the resources used to start and run a business.
b. Capital comes from investors (owners).
c. Capital comes from creditors (lenders).
III. Businesses can be classified as a for-profit organization or a not-for-profit organization.
a. A for-profit firm has the goal of making a profit for its owners.
b. A not-for-profit firm has the goal of providing goods or services to its clients.
IV. Both types of organizations add value—something customers are willing to pay for.
Teaching Tip
Use Exhibit 1.1 to explain the concept of adding value.
The Nature of Business Operations (LO 1)
I. The operation of the business depends on what it is organized to do.
II. There are four types of businesses.
a. Service organization – does something for its customers.
b. Merchandising business – sells a product to its customers.
i. Wholesale company – buys goods, adds value, and then sells them to other
companies.
ii. Retail company – buys goods, adds value, and then sells them to customers
who consume them.
c. Manufacturer – makes the products it sells.
d. Financial services firm – deals in services related to money.
Teaching Tip
Ask the students to suggest examples of each type of business: service, merchandiser,
manufacturer, and financial services. Point out that many businesses are combinations of one or
more types.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1-2
Ownership Structure of a Business (LO 1)
I. Business ownership usually takes one of three forms:
a. Sole proprietorship – a company with a single owner.
i. Not separate from its owner in terms of responsibility and liability.
ii. The business is the owner and the owner is the business.
b. Partnership – a company owned by two or more individuals.
i. Similar to a sole proprietorship.
ii. Not separate from the owners in terms of responsibility and liability.
c. Corporations – a special legal form for a business in which the business is a legal
entity separate from the owners.
i. Can have a single owner or a large number of owners.
ii. Ownership in a corporation is divided into units called shares of common
stock.
iii. Owners are called shareholders or stockholders.
iv. Stock exchange – a marketplace where buyers and sellers exchange their
shares of stock. Also called a stock market.
v. The Securities and Exchange Commission (SEC) – the agency that
monitors the stock market and the financial reporting of the firms that trade in
the market.
vi. Advantages of a corporation include diversification and limited liability.
vii. Disadvantages of a corporation include separation of management and
ownership and double taxation of corporate income. Dividends are the
earnings of a corporation distributed to the owners of the corporation.
Teaching Tip
Discuss with the students the advantages and disadvantages of each form of business ownership.
Business Activities and the Flow of Goods and Services (LO 2)
I. An entrepreneur is a person who starts a business.
II. Each step in the process of developing a business is classified as an exchange – who gets
what and who gives what in return. Exchanges are also called transactions.
III. A transaction is classified as:
a. Operating – related to the general operations of the firm.
b. Investing – related to buying and selling items that the firm will use for longer than a
year.
c. Financing – those transactions that deal with how a business gets its funding.
IV. An exchange or transaction involves who gets what and who gives what in return.
V. When an owner invests in the business, it is called a contribution or contributed capital.
a. Contributed capital is an owner’s investment in a company.
b. The business gives ownership.
c. The business gets capital.
VI. When a business repays a loan, it gives the economic resource of cash to the lender. This
amount includes the amount of the loan, called the principal, plus interest, which is the
cost of borrowing money.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1-3
Teaching Tip
Use Exhibit 1.3 to illustrate how a business works.
Information Needs for Decision Making in Business (LO 3)
I. Information is needed for decisions, such as:
a. How to finance the business?
b. What type of business organization to use?
c. Purchase/acquisition decisions.
d. Sales/collection decisions.
Teaching Tip
Ask students how a business comes up with the funds to acquire additional assets. Lead students
to see that a company can borrow (liabilities), or use invested funds (shareholders’ equity), or
hopefully, earn it (also shareholders’ equity). Later, you can associate the terms “paid-in capital”
and “retained earnings” with the latter two. Students may say that a company buys other assets
with cash; however, remind them that this would not change total assets.
II. An operating cycle begins with cash, converts cash to inventory, sells the inventory, and
turns the inventory sales back into cash.
III. Accounting information provides information about:
a. Revenue – the amount the company has earned from providing goods or services to
customers.
b. Expenses – costs incurred to generate the revenue.
c. What goods are left at the end of the period.
Teaching Tip
Use Exhibit 1.4 to illustrate the operating cycle.
Who Needs information About the Transactions of the Business? (LO 3)
I. Management
i. Information about what the business has done.
ii. Information about what the business is currently doing.
iii. Information about where the business is going.
II. The financial statements are based on a set of guidelines called generally accepted
accounting principles (GAAP).
a. The Securities and Exchange Commission sets the rules for corporations that trade on
public stock exchanges.
Teaching Tip
Point out that the SEC only has authority over the accounting rules of public companies—those
whose stock is traded on a public exchange.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1-4
b. The SEC has delegated much of its responsibility for setting financial standards to the
Financial Accounting Standards Board (FASB). The FASB is a group of
professional business people, accountants, and accounting scholars who have the
responsibility of setting current accounting standards.
c. The Public Company Accounting Oversight Board (PCAOB) is a group formed to
oversee the auditing profession and the audits of public companies.
d. The International Financial Reporting Standards (IFRS) are international
guidelines for financial reporting, used in many places around the world.
e. The International Accounting Standards Board (IASB) is the group that sets
international financial reporting standards.
Teaching Tip
Use Exhibit 1.5 to illustrate the relationships between the groups responsible for financial
reporting.
III. The Internal Revenue Service (IRS) is the federal agency responsible for federal tax
collection.
IV. A certified public accountant (CPA) is someone who has met specific education and
exam requirements set up by individual states to make sure that only individuals with the
appropriate qualifications can perform audits. To sign an audit report, an accountant must
be a CPA.
Overview of the Financial Statements (LO 4)
I. Four basic financial statements:
a. Balance sheet
b. Income statement
c. Statement of changes in shareholders’ equity
d. Statement of cash flows
II. The notes to the financial statements are the information provided with the four basic
financial statements that describes the company’s major accounting policies and provides
other disclosures to help external users better understand the financial statements.
III. Balance sheet
a. The balance sheet shows the accounting equation in detail.
b. It has three parts – assets, liabilities, and shareholder’s equity.
c. Describes the financial position of the company at a specific point in time.
d. Assets
i. Things of value owned by a business
ii. Provide future benefit
iii. Someone has a right (or claim) to the asset
e. Liabilities
i. Claims to the assets by creditors
ii. Amounts owed to those who have loaned to the company
f. Shareholders’ equity
i. Claims to the assets by the owners
ii. Also called net assets (Assets – Liabilities)
iii. There are two types – contributed capital and retained earnings.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1-5
iv. Retained Earnings is the total of all net income amounts minus all
dividends paid in the life of the company.
g. Accounting equation illustrated by the balance sheet
i. Assets = Claims
ii. Assets = Liabilities + Owners’ Equity
h. Heading
i. Name of the company
ii. Name of the financial statement
iii. Date (one specific date)
iv. Fiscal year is a year in the life of the business. It may or may not
coincide with the calendar year.
i. Comparative balance sheets are the balance sheets from consecutive fiscal years for
a single company.
Teaching Tip
Explain the balance sheet as a “snapshot” or “still-frame” photo of the business.
Teaching Tip
Use Exhibit 1.7 to illustrate how transactions affect the accounting equation.
IV. Income statement
a. Also known as statement of earnings, statement of operations, or profit and loss
statement.
b. The income statement shows all revenue minus all expenses for an accounting
period – a month, a quarter, or a year.
c. Net income equals all revenues minus all expenses for a specific period of time.
Teaching Tip
Explain the income statement as a “video” or “movie” of the business.
V. Statement of changes in shareholders’ equity
a. Statement of changes in shareholders’ equity starts with the beginning amount of
contributed capital and shows all changes during the accounting period. Then the
statement shows the beginning balance in retained earnings with its changes. The
usual changes to retained earnings are the increases from net income and the
decreases for dividends paid to shareholders.
b. Retained earnings are the total of all net income amounts minus all dividends paid in
the life of the company.
c. Retained earnings are not the same as cash.
d. Contributed capital
Additions – additional investments by owners.
i. Deductions – not covered in this course.
e. Retained earnings
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i. Additions – net income
ii. Deductions – dividends
f. Statement of changes in shareholders’ equity is the bridge from the income statement
to the balance sheet
VI. Statement of cash flows
a. Statement of cash flows shows all cash collected and disbursed during a period of
time. Each cash amount is classified as one of three types.
b. Cash from operating activities are cash transactions that relate to the everyday,
routine transactions needed to run the business.
i. Inflows – cash received from customers.
ii. Outflows – cash routinely paid to produce and sell goods and services.
c. Cash from investing activities are transactions involving the sale and purchase of
long-term assets used in the business.
i. Inflows – cash received from selling long-term productive assets.
ii. Outflows – cash paid to acquire long-term productive assets.
d. Cash from financing activities are transactions related to how a business is financed.
i. Inflows – cash received from investors (owners) or creditors.
ii. Outflows – cash paid to repay loans and make distributions (dividends) to
owners.
Teaching Tip
As an introduction to this topic, ask students where their money comes from and what they use it
for. Categorize their suggestions as operating, investing, or financing.
1. Operating – salaries/wages from jobs; rent payments, food, etc.
2. Investing – purchasing or selling investments; buying a house
3. Financing – borrowing or repaying money
Or,
Set up three unlabeled columns on the board (or screen, etc.). Ask students to call out any kind of
activity associated with a business. You can drop each item into the appropriate column and then
ask students to come up with names for the columns.
Teaching Tip
Ask students which of the three activities is most important and why. Also ask them whether
they believe cash flows in each area should be a net inflow or a net outflow.
Teaching Tip
Ask students whether they believe a net increase or a net decrease in cash is more desirable.
Teaching Tip
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1-7
Use Exhibit 1.14 to show how the financial statements are interrelated.
Real Company Financial Statements (LO 5)
I. Publicly traded corporations are ones that sell their stock on the public stock exchanges.
II. All publicly traded corporations must prepare the four financial statements every year.
III. One of the most important filings a company can make is the 10-K. It provides a
comprehensive overview of the business.
IV. The 10-K must be filed using a computer language called XBRL (Extensible Business
Reporting Language). This is a technology that enables firms to report information in a
standardized way that makes the data immediately available and interactive.
Business Risk, Control, and Ethics (LO 6)
I. Part of planning and running a business is identifying risks.
II. Risk is danger, anything that exposes us to potential injury or loss.
a. Risk that a product failure will result in death of consumers
b. Risk that someone will steal assets from the company
c. Risk that poor quality inventory will be purchased and sold
III. Risks relate to all aspects of the business.
a. General strategic risks – should we market our cigarettes to teenagers?
b. Operating risks – should we operate without a backup power supply?
c. Financial risks – should we borrow money or obtain investors?
d. Information risks – should we use a manual accounting system?
IV. Why take risks?
a. Every risk has a potential reward.
b. Controls are activities performed to minimize or eliminate certain risks.
Teaching Tip
Ask students to describe examples of risks that relate to a job that they have held.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1-8
CHAPTER 1 NAME ___________________________________
TEN-MINUTE QUIZ Section _____________ Date____________
_____________________________________________________________________________
_
_____ 1. The primary purpose of a business is to:
a. Pay taxes to the IRS
b. Sell a product
c. Sell goods and/or services to make a profit for the owner(s)
d. Help others
_____ 2. Sources of capital include:
a. Owners (investors)
b. Creditors (lenders)
c. Both A and B
d. None of the above
_____ 3. All of the following are types of for-profit businesses, except:
a. Merchandising companies
b. Service companies
c. Financial service companies
d. Charitable organizations
_____ 4. What is the name of the group that has much of the responsibility for setting
financial standards?
Public Companies Accounting Oversight Board
Financial Accounting Standards Board
Securities and Exchange Commission
None of the above
_____ 5. A business may be organized as a:
a. Corporation
b. Sole proprietorship
c. Partnership
d. Any of the above
_____ 6. A repayment of the principal of loans to creditors would be shown on the
statement of cash flows as a(n):
Operating activity
Investing activity
Financing activity
Revenue activity
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 1-9
_____ 7. Every business transaction is made up of:
a. Resources
b. Agents
c. Events
d. All of the above
_____ 8. The balance sheet contains information about:
a. Revenues and expenses
b. Cash inflows and outflows
c. Assets, liabilities, and equity
d. All of the above
_____ 9. The income statement provides information about:
a. The financial position of the company at a point in time
b. The financial position of the company for a period of time
c. The amount of cash generated by operations
d. The performance of the company for a period of time
_____10. Which of the following financial statements reports the financial position of a
company?
a. The statement of cash flows
b. The statement of changes in owners’ equity
c. The balance sheet
d. The income statement
ANSWER KEY - CHAPTER 1 – TEN-MINUTE QUIZ
C
C
D
B
D
C
D
C
D
C
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